What is the price of worthless information?

Consider the following hypothetical:

You meet a benevolent stranger on the street. Just assume that you have every reason to believe and trust him that the following offer is on the level. He has both $100,000 cash and $100,000 worth of an S&P 500 stock at current market value. His offer is to give you either the cash or the stock, but you have to pay him to learn what company the stock is for. It is the middle of regular business day; so the market price of the stock is changing as you decide, but once you decide, you get $100,000 worth at that moment (assume fractional shares are available).

How much do you pay?

The answer below the fold.

Hint: This might just be a story about Billy Joe and Bobbie Sue.

Highly linkable

Here is the first of what I hope is a regular feature here at MM.

Market Watch has some very sensible advice on retirement don'ts.

Arnold Kling looks at drug prohibition through the lens of his Three Axes. And he also takes on the tasks of persuasion through said lens.

Steve Horwitz explains some confusion about applying the conventional wisdom to the recommendations of Market Monetarist.

Stewart Baker discusses the recent denial of service attacks on banks allegedly propagated by Iran. It is true that regardless of the perpetrators this is not the equivalent of the Germans bombing Pearl Harbor.

Don Boudreaux takes a great, final for now, shot at explaining the problem with writing off debt we "owe to ourselves".

Mungowitz reminds us that incentives not intentions matter.

And Steve Landsburg's head hurts.

James Buchanan, RIP and ATRA

This past week we lost an intellectual giant, James Buchanan, whose contributions were and are still under appreciated. Among other contributions, Buchanan helped discover and bring to a fuller light facts that should have been obvious: political actors are subject self interest and incentives just like everyone else and government failure is as much if not more a fact of life as is market failure.

See these excellent appreciations of the Mr. Buchanan's life work:
     From Alex Tabarrok
     From Steve Horwitz
     From Arnold Kling
     From Don Boudreaux
     and From the WSJ editorial page

It is a bit fitting unfortunately that Buchanan's death would come so closely to the passage of the American Tax Relief Act of 2012 (ATRA)--the resolution to the so called tax portion of the Fiscal Cliff. This disgusting example of political corruption would have been well understood by Buchanan. The act contains nothing resembling fiscal responsibility or improvement. It is a giveaway to the special interest of the tax lobby (tax preparers, tax advisors, estate lawyers, et al.) and other corporate special interest. It leaves us with a tax code more punishing on work and savings, more complicated, more encouraging of the rich to spend and use rather than save and share, more taxing on all taxpayers as everyone's income tax burden has increased (not just but especially those making more than a couple hundred thousand in a particular year--the $450,000 is a fiction), and more likely to bring us fiscal problems down the road. But it should have all been of no surprise to any of us; I was not surprised. The whole thing reminds me of this exchange:

Muriel Blandings: You remember Bunny Funkhouser, dear, that clever young interior decorator that we met at the Collins' cocktail party.

Jim Blandings: You mean that young man with the open-toed sandals? What about him? 

Muriel Blandings: Well, you know how long we've said we've got to do something about fixing up this apartment. Well, a couple of weeks ago, he called, and I asked him to come over, and he had some simply wonderful ideas, and I didn't want to bother you with sketches and estimates until I knew whether we could afford it. So I sent them over to Bill. 

Jim Blandings: How much? 

Muriel Blandings: What's the point in asking how much until you know what you're going to get?

Jim Blandings: I've seen Bunny Funkhouser. I *know* what I'm going to get. 

RIP, James Buchanan. We still have a lot to learn from you.

Helium: a lesson on "shortages", preferences, and rationing

The Independent reports on the latest scare in precious commodities. It seems we are running low on helium. "Low" is a relative and subjective term, of course. We are also running low on gold, beach-front property, private airplanes, and a bunch of other stuff. It's been that way for some time. I guess it is only news when a scientist complains.

"...Now supplies are running so low scientists want to ration it."

Maybe these scientists at Cambridge should head over to the Econ department to see if anybody has ever come up with a good way to ration scarce goods.

I like this quote as well:

"Cheap helium also drives misuse. A staggering 8 per cent of the world's helium supply is currently used for filling party balloons," he said.

I like how only scientists get to define "misuse". What would the buyers and sellers of party balloons say?

But he does seem to understand something about market interference:

"It is difficult to imagine an adequate market incentive to collect helium during natural gas extraction while the US government is selling off its entire stockpile at bargain prices," Dr Stokes said.

Professor Ned Brainard was unavailable for comment.

I've made a huge mistake

Here is another idea on a New Year's Resolution: Find a better balance between the "I should haves" and the "I should not haves". They are generally tradeoffs against each other where any minimization of one implies an increase in the other, but innovations can allow for new possibility sets where the minimums of both are lower. Think of this as greater efficiency. An example would be finding a new destination for a vacation to replace an old standard.

Think of it in terms of cruise ships. If you find a better cruise ship line, you might find that all choices aboard have better outcomes. For example, staying in your cabin for the day is more pleasant because the room is nicer than on the previous ship, but venturing out to take in activities is also an improvement over the previous ship's alternatives. Even if your relative costs are higher because everything aboard is so fabulous that the alternatives on the ship have high absolute differences (restaurant A might be a big let down compared to restaurant B), the effect still holds because the overall possibilities are better than what they were before (restaurant A is better, the same, or just slightly worse than the best restaurant on the prior ship while nearly everything else on the new ship is much better). Of course, it might take an initial risk of an "I should not have" to deviate from the original, known cruise ship, but that is the point of the resolution--taking desirable chances.

So my recommendation is two-fold:

• Evaluate your life to see if you need less "I should haves" or less "I should not haves";
• Appreciate and expose yourself to the opportunity to reduce both.

This is what Tim Harford is getting at in his resolution.

PS. Some of you probably recognize the more scientific form of what I describe above. Namely, the tradeoff between Type I and Type II errors and how a technological change can allow both to decline simultaneously.  Good for you, you get extra credit to apply toward the final exam.

Vegas observations

I'm just back from Vegas, baby! and have a few observations to share:

• They didn't give daddy the Rainman suite, but they treated me well. Stayed at the Venetian, which is a hard act to beat and maybe the best option in town for a family such as us.
• Vegas has got to be the people watching capital of the world. Perhaps someday (hopefully) a cross section of the world will in fact be as wealthy and glamorous as the Vegas Strip population appears, but it will perhaps (unfortunately) also be just as shallow.
• Speaking of watching the shallow-minded people, it is fun to hear how confident foolish people can be. Craps and Blackjack are the penultimate examples of this. This observation deserves its own breakdown:
• It is amazing how many people have a long history of "always paying for their trips with their (Craps, Blackjack, et al.) winnings". I don't see how those casinos can afford to keep the lights on. Perhaps we should take up a collection.
• The ability to add quickly does not make you "good at math". Knowledge of mathematical principals, ability to see things in algorithmic terms, and appreciation for underlying systems like probability are qualities of good mathematical minds. They don't give out many Fields Medals for counting. To conflate that you can add up an Ace, Seven, Queen, and Four quickly or pay out at 6:5 odds on $15 bet with $75 backing it up in a swift motion with being "good at math" is like saying spelling bee performance is highly correlated with great writing in literature.
• The human mind is ridiculously susceptible to the lure of superstition. 
• How much can you really make in tips standing on the Strip in a creepy, B-level children's entertainment character costume? Apparently enough as compared to about 20 people's next best option.
• The variety of hotel casinos reminds me that it takes all kinds. I hear you say, "Is that what it takes? I always wondered what it took." But it is as true here as ever. A Las Vegas central planner would probably be a lot like Steve Wynn. His design would be remarkable, beautiful, distinctive, and exclusive while also being unappealing and unavailable to most. His monopoly status would promise unprofitability if without subsidy. Or the planner would be like the group that runs Caesars Entertainment Corporation (the owners of Caesar's, Harrah's, and a host of additional properties that appeal to a group much less sophisticated than the Encore set). The place would be tacky without perspective and a "big-box" version of a gaming destination. The monopoly status would again promise unprofitability if without subsidy. Fortunately, we have a mostly free-market approach, which allows for some, really a lot, of both styles with many degrees in between, above, and below. It is just important to realize that the right side of the distribution (almost no matter what distribution we consider: quality, variety, quantity, price, etc.) necessitates a left side. 
• I'm glad I saw this excellent piece in the New Yorker after my trip. I would have been even more paranoid about street crime. Watch the video as well. (hat tip: Kottke)

PS. Don't be misled by my hypothetical on a Las Vegas central planner. I very much admire the entertainment products of both Steve Wynn and the Caesars group. 

An outsider's view of insider trading

As an investment professional, I follow the insider trading laws. And as a CFA charterholder, I follow the more rigorous ethics required by the CFA Institute. But I don't believe in insider trading restrictions. That is I don't subscribe to the theory of justice underpinning insider trading prohibitions. I would like to see these prohibitions largely changed to the extent of elimination generally. I believe this would be an improvement to our society's justice and economic/market efficiency.

The idea of prohibitions on insider transactions hinges on the idea that profiting from knowledge is good but profiting from too much knowledge is bad. Those supporting insider trading restrictions would probably say I've got that wrong. That it isn't too much knowledge but rather unfair knowledge. My answer to that is there is no principled concept of "fair" that allows one to draw a line in the way insider trading laws do making the distinguishment between fair knowledge and unfair knowledge. It takes logical magic tricks to make the distinction. Simply put, the distinction is arbitrary, which is antithetic to logical principals. The arbitrariness can be seen in how ridiculously vague the insider laws are. This makes for dangerous risks--it puts arbitrary power in the hands of already powerful people.

Let's make clear a couple of points. In my opinion insider trading prohibitions are not about prohibiting fraud or misrepresentation. Hence, reducing or eliminating them would not be any sort of condoning of fraud or misrepresentation. They are about making illegal a victimless crime that has in the general public opinion a very negative perception (people benefiting from too much information).

Prohibiting insider trading has several very real negative effects:

• It violates property rights--the right to freely buy and sell in the market.
• It reduces economic/market efficiency by limiting who can bring knowledge into the price system.
• It promotes a false sense of security (moral hazard) by promising that securities transactions are between generally equally equipped traders--this illusion as well as the above problem with market efficiency is mitigated by the next effect.
• It drives some market transactions (insider transactions) into the dark and gives pause to other transactions for fear of raising insider suspicions. This is very much like the negative effects an onerous, complicated tax system brings--wasted resource allocation in compliance and reduced otherwise beneficial activity in avoidance.

My solution is disclosure-based insider trading rules. I am not alone in this idea. Basically I would like to see insider trading laws replaced by a rule requiring open disclosure of any "significant" transactions from an "insider". I would let the courts decide what a "significant" transaction would be, but as a guidance perhaps a trade over $10,000 in notional or exercise value. I would expand the definition of an "insider" to include any employee of a firm (not just the current definition which includes a company's officers, directors and any beneficial owners of more than 10% of a class of the company's equity securities) and as with the current definition any individual who trades shares based on material non-public information in violation of some duty of trust whether inherent or imputed (e.g., getting a tip from the CEO one could reasonably expect was material non-public information). Now more truly if you're not "inside", you're "outside". Failure to properly disclose an insider trade would result in a fine equal to say 25% of the gross profit from the alleged trade. Any employee trade not properly disclosed would also result in the same fine incurred by the employer unless the employee was acting with malicious intent. 

The reason companies would find this change to be largely in their interest is the same reason why companies would want restrictions on insider trading in many cases. Companies have at least two reasons why they don't want their officers making some kinds of insider trades: 

1. It makes for very negative PR for a CEO to sell (buy) the company stock on insider knowledge that negative (positive) news is forthcoming. 
2. A company wants a CEO's incentive to be with the long-term interest of the company whereby he gains (looses) as the firm gains (looses). (Unfortunately, we continue to allow insiders to avoid losses their firms incur generally at tax-payer expense. But that is a problem for another blog post.)

I would anticipate greater popularity of agreements between corporations and their insiders that allow for clawback of earnings or outright damages for insider trades not in company interest.